For the quarter, the yield curve steepened with short maturity yields up 20 basis points¹, while intermediate and long maturity yields increased 60 to 80 basis points. This, along with wider credit spreads, drove negative municipal index returns. In addition, intermediate and full maturity municipal indexes fell 0.8% and 2.9%, extending this year’s losses to -5.6% and -9.0%, respectively. With the overhang of heavy bid lists all year, municipal trading liquidity has been strained, placing a premium on generic high-grade 5% coupon bonds. Our portfolios generally performed in-line with their benchmarks for the quarter. The higher quality orientation of our portfolios has helped, but our housing authority exposure has been among the worst performing sectors. Also, we have been surprised that in a year of rapidly increasing Fed tightening expectations, our floating-rate notes would perform so poorly. Year-to-date we have leaned into both of those areas, looking to capitalize on historically wide spreads.

Despite its intensity, we would not characterize this year’s selling pressure as a crisis. Unlike the widespread credit fears of early-2020, most municipal issuers are in better shape today than they were pre-pandemic. In many respects, 2021 was a record year and we expect it to serve as the high-water mark for governmental revenues over the next few years. However, today’s high inflation represents a challenge to credit. So far, most governments have shrugged off the inflationary threat, courtesy of record federal aid and rainy-day fund balances. Ironically, this federal aid has been a major cause of the inflation we are experiencing today.

We view inflation as a regressive tax, which disproportionately harms low and middle-income households. Several states have utilized their strong positions to help shelter taxpayers from ever growing costs. A handful of states have lowered income tax brackets, while others have implemented gas tax holidays. Some governments also plan to expand social spending as more Americans struggle to meet their basic needs (see Exhibit II). While governments can afford to be generous in the near term, our expectation is that, should inflation persist, it will slowly erode municipal finances over time, reducing future generosity. This leads to a classic tug of war between a government’s responsibility to its citizens and its responsibility to its creditors.

The Fed’s actions to combat inflation will leave a meaningful impact on credit. With higher borrowing rates, rising labor costs, and increasing building costs; capital projects will place a greater strain on budgets. Beyond the direct impact of rising rates, the Fed’s actions are driving the U.S. economy in the direction of a recession. During the euphoria of 2021, we shook our heads as we watched many deals for questionable credits or projects come to market at even more questionable yields. Now, issuers and investors will likely face a more difficult credit environment, one that will punish undisciplined approaches. The last downturn was quickly reversed by enormous federal support, but that will not likely be the case this time. The prior monetary and fiscal stimulus only served as a band aid, covering up issues that can only be solved through reform. We have witnessed no such reforms and were incredulous when the rating agencies handed out many upgrades to weak issuers. This is yet another reminder of the importance of independent credit research.

Municipal credits have not had to face conditions like these for 40 years, but they are no strangers to hard times. During the GFC, we witnessed most states and local governments adjust to their new economic reality by making the tough decisions to cut spending and deleverage. As credit conditions tighten and the weight of the Fed’s inflation fight slows down economic activity, we expect greater differentiation in credit pricing. We began to see some of this emerge during the second quarter with Single-A and Triple-B rated securities underperforming high-grades by 100 and 200 basis points, respectively. We remain focused on durable credits that can control their own destiny and protect their market access. Owning these credits helps preserve our clients’ capital and allows us to take advantage of opportunities in choppy markets.

Higher yields, wider spreads, and rampant forced selling have generated widespread opportunities. In contrast to a subdued 2021, our portfolio activity has picked up meaningfully. Unlike the last couple of years, during which our purchases were concentrated in bonds with non-standard coupon structures, this year we have also identified opportunities in bonds with standard coupons. We added a wide range of credits during the quarter, including airports from Houston, Fort-Lauderdale, and Metropolitan D.C., and a very strong healthcare provider, Atrium. Among our highest spread purchases were two-year MTA floaters at +175 basis points, a five-year put bond from Ohio backed by Duke Energy at +170 basis points, and several four-to-five-year State Housing Authority bonds at +115-135 basis points.

We also added several high-quality, longer positions during the quarter such as Ohio general obligation bonds and Utah appropriation debt to rebalance duration. Most municipal bonds with original maturities greater than 10 years are callable and, as rates have climbed, are less likely to be called prior to maturity. Consequently, the duration of our benchmarks has extended, creating a gap with our portfolios which did not hold as much callable bond exposure. We took advantage of today’s higher yields to add high-quality, longer bonds and reduce this duration gap.

We have invested through many difficult periods throughout our careers. This year has surely presented unique challenges as today’s 40-year high inflation is producing serious repercussions for living standards, economic policy, and financial markets. Unlike the recent past when the Fed was quick to abandon its tightening path in the face of weakening financial markets, there is little doubt that inflation fighting will continue to take precedence above all other considerations. Ironically, the strength of the U.S. economy entering 2022, as well as strong household wealth and income growth, may require the Fed to go further than might otherwise have been the case. To us, this all adds up to more risk on the horizon. Attractive long-term opportunities often arise from short-term volatility. Taking advantage of these opportunities requires patience, selectivity, and a long-term orientation – nothing else matters.

Sincerely,

Gregory S. Steier
Porftfolio Manager